When to Create an LLC: Everything You Need to Know
When determining when to create an LLC (limited liability company), small business owners must consider several factors. Factors vary from state to state.3 min read
2. LLC Disadvantages
3. Establishing an LLC
When determining when to create an LLC (limited liability company), small business owners must consider several factors. Though a variety of entity options are available, including corporations, the LLC is the most popular among sole proprietorships and small businesses because it's the easiest and most inexpensive way to structure a new company.
Benefits of Forming an LLC
The LLC entity was created during the 1970s to streamline the process of structuring a small business. In many states, you simply need to file articles of organization, pay a fee, and sometimes make annual filings.
In addition to these requirements, however, LLCs with more than one member should create an operating agreement to detail management of the business, including profit and loss allocation, voting rights, authorizations, and compensation. Members can draft this document themselves or with the assistance of a business attorney.
An LLC is treated as a pass-through entity by the IRS, which means profits and losses are reported on the members' individual income tax returns and the entity does not pay income tax at the corporate level. Single-member LLCs file Schedule SE to pay self-employment taxes and Schedule C to list revenues and deductions. LLCs with more than one member must file Form 1065 along with a Schedule K-1 for each member that details his or her portion of credits, profits, and losses. An LLC can also opt to be taxed as a C or S corporation.
Like C and S corporations, LLCs offer limited liability protection. This means members' personal assets are protected from creditors and legal judgments. The exception is when a member is negligent, commits a crime, or engages in fraud, or if he or she personally guarantees a loan.
Forming a legal business entity such as an LLC can increase your credibility with employees, customers, partners, and vendors because you have made a significant commitment to your company.
LLC members can have any organizational structure they see fit. The business can be managed by the members themselves or by managers appointed by the members. Corporations, on the other hands, are managed by a board of directors who elect officers to administer daily business operations.
LLCs are subject to few ownership restrictions.
Although the LLC is an ideal entity for many small businesses, it does have potential drawbacks:
- It's difficult to raise money from venture capitalists and other investors because of its flexible governance and other features.
- Unlike a corporation, which can sell stock shares to investors, transferring LLC ownership can be difficult and may require the approval of other members.
- LLCs have not been around as long as corporations, so less case law and legal precedent exists.
Establishing an LLC
The process of creating a new LLC is relatively simple. First, you'll need to choose a name that is not already used by another business in your state and complies with the state's naming regulations. This includes avoiding restricted words and using the phrase Limited Liability Company or LLC in the business name. Some states also have other restrictions.
Once you have a name, you'll need to file a simple document usually called the articles of organization. Most states have a standard form that requires you to fill in the business name, address, purpose, and other information. It must be signed by one or more LLC members. The filing fee varies by state from as little as $100 to several hundred dollars.
Most states require you to appoint a registered agent who is responsible for receiving legal documents on behalf of the LLC. This can be one of the members or a professional service.
Some states require you to publish a notice of your intent to form an LLC in the local newspaper for a specific period of time. You'll then receive an affidavit of publication which must be filed with your articles of organization.
If your LLC has more than one member, it's important to create an operating agreement to avoid future disagreements. In most cases, this document can be relatively simple and doesn't need to be filed with the state. This legally binding agreement details the rights and responsibilities of each LLC member, along with ownership percentages and other policies and procedures.
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